Mispriced Stocks Break the Rules of Efficient MarketsResearch by Owen A. Lamont and Richard H. Thaler
According to the law of one price, identical assets should have
identical prices. Driving this law is arbitrage, in which an
investor buys and sells the same security for two different
prices to make a profit. In a well functioning capital market,
arbitrage prevents the law of one price from being broken, and
in fact, violations of the law are rarely seen.

Consider the investor who buys an ounce of gold in London for
$100 and sells the gold in New York for $150, locking in a profit
of $50. This is an example of arbitrage. As a result, the price
in London should be driven up, and the price in New York should
be driven down so that arbitrage is no longer possible.

During the recent boom in technology stocks, several cases
emerged where the law of one price was violated, and high transaction
costs limited arbitrage, allowing the mispricing to persist.

Two University of Chicago Graduate School of Business professors,
Owen A. Lamont and Richard H. Thaler, investigate these unusual
cases in their paper, "Can the Market Add and Subtract?
Mispricing in Tech Stock Carve-Outs."

Their study focuses on recent equity carve-outs in technology
stocks in which the parent company has stated its intention
to spin-off its remaining shares. Lamont and Thaler examine
several cases of mispriced stocks and document the precise market
friction that allows prices to be wrong, concluding that two
things are necessary for mispricing: trading costs and irrational
investors.

Not One Price But Two

Also known as a partial public offering, an equity carve-out
is defined as an IPO for shares (typically a minority stake)
in a subsidiary company. A spin-off occurs when the parent firm
gives remaining shares in the subsidiary to the parent's shareholders.

The most prominent example of mispricing in this study is the
case of Palm and 3Com. Palm, which makes hand-held computers,
was owned by 3Com, a profitable company selling computer network
systems and services. On March 2, 2000, 3Com sold 5 percent
of its stake in Palm to the public through an IPO for Palm.
Pending IRS approval, 3Com planned to spin off its remaining
shares of Palm to 3Com's shareholders before the end of the
year. 3Com shareholders would receive about 1.5 shares of Palm
for every share of 3Com that they owned, thus the price of 3Com
should have been 1.5 times that of Palm. Investors could therefore
buy shares of Palm directly or by buying shares embedded within
shares of 3Com. Given 3Com's other profitable business assets,
it was expected that 3Com's price would also be well above 1.5
times that of Palm.

The day before the Palm IPO, the price of 3Com closed at $104.13
per share. After the first day of trading, Palm closed at $95.06
per share, implying that the price of 3Com should have jumped
to at least $145. Instead, 3Com fell to $81.81.

The day after the IPO, the mispricing of Palm was noted by
the Wall Street Journal and the New York Times. The nature of
the mispricing was easy to see, yet it persisted for months.

In cases of equity carve-outs, a negative "stub value"
indicates an extreme case of mispricing. The stub value represents
the implied stand-alone value of the parent company's assets
without the subsidiary, a projection of what the company will
be worth after it distributes these shares.

In the case of Palm and 3Com, after the first day of trading,
the stub value of 3Com, representing all non-Palm assets and
businesses, was estimated to be negative $63, a total of negative
$22 billion. Since stock prices can never fall below zero, a
negative stub value is highly unusual.

To study this and other cases of mispricing, Lamont and Thaler
built a sample of all equity carve-outs from April 1985 to May
2000 using a list from Securities Data Corporation. They combined
this list with information on intended spin-offs from the Securities
and Exchange Commission's Edgar database. The final sample contained
18 issues from April 1996 to August 2000.

In order to focus on cases of clear violations of the law of
one price, they looked for potential cases of negative stubs.
Besides Palm, they found five other cases of unambiguously negative
stubs in their sample, all technology stocks: UBID, Retek, PFSWeb,
Xpedior, and Stratos Lightwave. While the number of negative
stubs is not significant, even a single case raises important
questions about market efficiency. The fact that five other
such cases of mispricing existed indicates that the highly publicized
Palm example was not unique.

The time pattern of these six negative stubs suggests that
the stubs generally start negative, gradually get closer to
zero, and eventually become positive. This implies that market
forces act to correct the mispricing, but do so slowly, reflecting
the sluggish functioning of the market for lending stocks.

Problems with Shorting

To determine ways that an investor could profit from the mispricing,
Lamont and Thaler tested an investment strategy of buying the
parent and shorting the subsidiary, which on paper yielded high
returns with low risk for these six cases.

In order to short a stock, an investor bets that a stock will
go down in value and looks for an institution or individual
willing to lend shares of this stock. The investor then borrows
the shares, sells them to another individual, and later buys
the shares back at a hopefully lower price to cover the short.
Buying the shares back at this lower price yields a profit for
the initial investor.

While these negative stub situations present attractive arbitrage
opportunities, the high returns Lamont and Thaler calculated
are difficult to realize due to problems with shorting the subsidiary.

The chief obstacles to arbitrage in these cases were short
sale constraints, which make shorting very costly or impossible.
In some cases, institutions or individuals may be unwilling
to lend their shares to short sellers, the cost of borrowing
the share may be too high, or the demand for shares may exceed
what the market can supply, creating a price which is too high.

Many investors were interested in selling the subsidiaries
short for the six cases in question. In the case of Palm, at
the peak level of short interest, short sales were 147.6 percent,
indicating that more than all floating shares had been sold
short. Given that the typical stock has very little short interest,
it is extremely unusual that more than 100 percent of the float
was shorted.

As the supply of shares grows via short sales, the stub value
gets more positive, indicating less demand from irrational investors,
and causing the subsidiary to fall relative to the parent.

Next, Lamont and Thaler studied the options market for more
evidence on how high shorting costs eliminate exploitable arbitrage
opportunities. Options can make shorting easier, both because
options can be a cheaper way of obtaining a short position and
because options allow short-sale constrained investors to trade
with other investors who have better access to shorting.

In a well-functioning options market, one expects to observe
put-call parity. A put is the right to sell a stock at a certain
price, and a call is the right to buy a stock at a certain price.
These two rights together allow an investor to reproduce the
stock itself, synthetically creating a security identical to
Palm, for example. Under the law of one price, this bundle of
securities that mimics Palm should have the same price as Palm.

"The concept that a bundle of securities should have exactly
same price as whatever it replicates is the most fundamental
thing in all of finance-the law of one price," says Lamont.

The options on Palm display unusually large violations of put-call
parity, with puts about twice as expensive as calls. Calculating
the implied price of synthetic securities, Lamont and Thaler
found that on March 16, 2000, the price of the synthetic short
was about $39.12, far below the actual trading price of Palm,
which was $55.25 at the time. This difference in prices indicates
a significant violation of the law of one price, since the synthetic
security was worth 29 percent less than the actual security.

The options prices confirm that shorting Palm was either incredibly
expensive or that there was a large excess demand for borrowing
Palm shares that could not be met by the market.

"Given that arbitrage cannot correct the mispricing, why
would anyone buy the overpriced security?" write Lamont
and Thaler. One plausible explanation is that the type of investor
buying the overpriced stock is ignorant about the options market
and unaware of the cheaper alternative. In looking at who buys
the expensive shares and how long they hold them, Lamont and
Thaler find numerous patterns consistent with irrational investors.

Larger Problems for the Market?

While Lamont and Thaler do not generalize that these overpriced
stocks reflect problems with all stock prices, their evidence
casts doubt on the claim that market prices reflect fundamental
values because these cases should have been easy for the market
to get right.
Their analysis offers evidence that arbitrage doesn't always
enforce rational pricing.

If irrational investors are willing to buy Palm at an unrealistically
high price, and rational but risk averse investors are unwilling
or unable to sell enough shares short, then two inconsistent
prices can co-exist.

One law of economics that still holds is the law of supply
and demand, namely that prices are set where the number of shares
demanded equals the number of shares supplied. If optimists
are willing to bid up the shares of some faddish stocks, and
not enough courageous investors are willing to meet that demand
by selling short, then optimists will set the price.

"Regarding tech stocks in general, I don't think that
there were enough pessimists shorting the NASDAQ in March 2000,"
says Lamont. "The short sale constraints that applied to
Palm were not true for the entire NASDAQ. It would have been
easy to short the whole market with futures, for example, but
basically no one shorts. This means that sometimes the optimists
go crazy, and things get overpriced."

Lamont adds, "Whether you are an executive doing a takeover
or buying the stock for your own account, if stocks can get
overpriced, the key to success is identifying what's overpriced
and avoiding it."

Owen A. Lamont is associate professor of finance at the University
of Chicago Graduate School of Business. Richard H. Thaler is
Robert P. Gwinn Professor of Behavioral Science and Economics
at the University of Chicago Graduate School of Business.